Debt consolidation can be a great way to lower your monthly payments, lower your interest charges, and streamline the process of paying off what you owe. But consolidation is not always the right choice and it is not necessarily a risk-free process.
To make sure that debt consolidation does not make your situation worse, it is important to understand the dangers so that you can make an informed choice as to whether consolidating your current debt makes sense for you. Here are four major risks associated with the process that you will want to mitigate if you are considering taking this approach.
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1. Get into deeper debt
One of the biggest risks in debt consolidation is that you will apply for new credit without resolving the spending issues that caused you to go into debt in the first place.
If you take out a personal loan or get a balance transfer card to pay off existing debt, you will now have plenty of credit available on the cards you transferred balances from. If you turn around and start charging on these cards, they could soon have high balances again – and you will owe on your consolidation loan as well.
To avoid making this mistake, don’t consolidate your debt until you have a plan to avoid overspending. Set a budget that you will live on, ideally start saving for an emergency fund, and promise not to use your newly released cards for purchases.
2. Pay more in interest
One of the main advantages of debt consolidation loans is that you can lower your interest rate. A personal loan or credit card offer with balance transfer 0% interest for a limited period of time can all carry much lower interest rates than existing credit card debt. However, your interest rate is not the only factor in determining the amount of interest you will pay.
Your debt repayment schedule also plays a large role in the total interest charges you will incur. If you take out a debt consolidation loan and reduce your monthly payments by extending your repayment period, your interest rate may be lower but your total costs higher since you are paying interest over such a long period.
Suppose you owe $ 2,000 on a 15% interest credit card and $ 3,000 on a 20% interest card and pay $ 200 per month for each card. Your debt would be paid off in 1.5 years (18 months) and you would pay a total of $ 629 in interest. But, if you took out a 36 month consolidation loan at 9.24% and took all the time to pay off the loan, your monthly payments would drop from the $ 400 you were paying to $ 159.56.
Sounds good, but the problem is, even at a lower interest rate, your total interest cost would be much higher. This is because you would be paying interest for the 36 months it took to pay off the personal loan, rather than 1.5 years. You would pay a total of $ 744 in interest, or $ 115 more.
You could avoid this problem by continuing to make the same monthly payment – or a greater amount – on the new loan used to consolidate debt. Just make sure you don’t have a prepayment penalty on the consolidation loan.
3. Get caught in a consolidation scam
Some lenders specifically market debt consolidation loans to consumers who are experiencing financial difficulties. Unfortunately, many of these loans are not very consumer friendly. The interest charges can be very high, the terms of the loan can be very long, or there can be other adverse terms such as exorbitant penalties for a single missed payment.
You don’t want to get caught up in debt consolidation scams, so research loans and lenders carefully. Compare the interest rates, terms, and total costs of the loan, and look for complaints about the lender you are working with. The Consumer Financial Protection Bureau has a useful database of consumer complaints to use.
Or, just stay away from these “debt consolidation lenders” and go for a standard personal loan or a balance transfer credit card instead and you won’t have to worry about this problem.
4. Putting your home or retirement at risk
There are different ways to consolidate debt, including personal loans and balance transfers, both of which can be great options for lowering your rates without taking on a lot of additional risk.
But, some borrowers will take out home equity loans to pay off existing debt or borrow from a 401 (k). Doing either of these things can be very risky, because if you don’t pay off your loan, you will put your home in jeopardy or you will face a 10% penalty and pay tax on the loan. income on money withdrawn from your retirement account.
While it might seem like paying a really low interest rate with a home equity loan or paying yourself interest with a 401 (k) loan, you should think very carefully about converting credit card debt. unsecured – which have no collateral attached to it – with one of those loans that carries such a high risk.
Consolidate your debt intelligently
You can smartly consolidate debt using a credit card or personal loan, after budgeting to avoid overspending in the future. If you take this approach, consolidation can be a great first step towards paying off debt and improving your overall financial situation.